Red Herring Futures Part 2: Fire is Always Hot, and a Woodstove Won’t Heat Your House

In Episode One of the quest for red herring futures (published in this newsletter last Monday), I talked about the need to properly identify a problem before it can be effectively fixed. Failing to do so often leads to a toaster-jerk reaction, which looks pretty foolish and has no better than a pure-accident chance of making things better. I also promised that I’d explain how the presence of speculators cannot be a base cause for high prices or extreme volatility in a market. As I always keep promises that are convenient, let’s get started.

Please note that at no point have I stated that speculative activity is unrelated to volatility or price change. It’s not only related, it’s one of a limited set of vehicles specifically designed to realize such behavior. What I’m saying is that barring exceptional cases like willful fraud or manipulation, it cannot be a root cause. Allow me one analogy to explain. Since heat is a popular topic here in the arctic in winter time, I’ll work with that.

I have a woodstove in the living room, because the floor heater alone just can’t compete against weeks of -25C temperatures. My woodstove keeps the living room cozy… well, sort of, but not really. All the woodstove does is provide a safe and efficient means to burn a wood fire. The stove itself does not produce heat; it merely contains and directs the heat produced by the fire.

So if I’m sitting in my living room shivering because my woodstove (with no fire in it) is doing a lousy job of heating the house, then I’m not very bright. If I install three more woodstoves in the living room to increase heat output (still not lighting fires), I’m an idiot. If it’s uncomfortably warm in the house in the summertime, removing the unused woodstove from the living room won’t do anything but make a mess.

A woodstove doesn’t heat your house. It’s just a vehicle, a tool to deliver the fire-generated heat.

But while a woodstove may or may not be hot, the same is not true of the fire inside. If you pile wood together and light it ablaze, you always get heat from it. Though many factors can vary the amount of heat, you still get something every single time. You don’t ever burn wood and get the opposite reaction, e.g. “Holy cow, now it’s getting colder; the fire is sucking the heat from the room”.

With that said, let’s get back to financial markets. If speculation is the CAUSE of extreme volatility and high prices, then just like fire, the presence of speculation MUST consistently produce that reaction in a market. “Sometimes” is not enough, just like a fire cannot produce heat only some of the time.

The most excellent test case I can think of is the onion market. Once, speculators were allowed to trade onion futures. In the 1960’s, the speculators were accused of being the cause behind extreme volatility and high prices in that market (those accusations used much the same language as is used for oil speculators today, by the way). A law was passed banning speculation in that market to establish order and control.

Were speculators really the cause of the volatility? To answer that, you have to answer two other questions. First, were crazy volatility and high prices always present in the onion market prior to the speculation ban? Second, once the ban was enacted, was there a substantial, consistent and persistent reduction in prices and volatility, demonstrating that in the absence of speculators, the market became stable and safe?

First answer: No. Prior to the ban, with speculators present, onion futures were at times low-priced, and there were periods of time where price change was orderly and gradual. There were also periods where volatility was extreme and prices went very high and low, very fast.

Second answer: No. There were definitely periods of quiet and order after the ban. But there were also periods of high price spikes and extreme volatility.

In other words, the market demonstrated both quiescent AND extreme behavior whether speculators were present or not. In fact, in recent years (since 2000), record volatility and prices put to shame what they were complaining about in the 1960’s. (the price chart I’m referencing, along with a nice writeup, can be found in a 2008 post on the Carpe Diem blog, run by Professor Mark Perry, at http://mjperry.blogspot.com/2008/06/what-onions-teach-us-about-oil-prices.html).

Speculation CANNOT be a cause for high prices and volatility because it does not produce high prices and volatility every time that it is present. As demonstrated in every futures market that allows speculation, sometimes prices are volatile, sometimes not. In markets where speculation is not allowed, sometimes prices are volatile and sometimes not. You simply cannot create a cause-and-effect relationship there unless you have a secondary agenda. Or a toaster in your hand.

Speculators are woodstoves. They react to environmental conditions and stimuli and place their trades accordingly. Sometimes speculators act together; sometimes they oppose each other; and sometimes they don’t participate at all. But they do not cause high prices; they realize them by all buying at once. The combination of factors that is making speculators all buy at the same time, is the cause for the high prices.

Why is this distinction important? Because trying to lower prices by removing speculators is like trying to make your house cooler in the summer by removing your woodstove. It’s a toaster-jerk reaction. If you want to cool your house down, you need to know what is causing the high temperature and mitigate that. If you want to reduce prices, then you have to change the cause – not the vehicle – for the high prices.

What if speculators are conspiring to trade together and raise prices? That’s bad if ANYBODY is doing it, so find evidence of it, prove it, and throw ‘em in jail. “Everybody is buying,” by itself isn’t evidence of illegal activity, though; manipulation requires deliberate cooperation. Memes don’t count as evidence either (as in, “Everybody knows all the big Wall Street banks are out to screw America”), so don’t even start that with me.

But isn’t speculative activity magnifying volatility and making things worse? It can do that, yes. But I think I can demonstrate that in some cases, there’s simply no escape from high prices and high volatility (or extremely low prices, or long periods of inactivity, or whatever other kind of market behavior you’d like to mention). I’ve already sneakily mentioned it here, but I’ll need a third part to cover the mechanics of price change, the evils of agreeing with each other, and why long-only passive trading isn’t quite the monster under the bed that it’s purported to be.

Thank you again for reading. My views are my own, and I speak only for myself. Comments and feedback are appreciated, especially if you agree with me, or at the very least have a shrewd logical observation that I’ve missed that renders my entire argument invalid.